Selectively Greedy in Midstream Energy

The meltdown in the midstream energy sector may be an overreaction, but it also reflects legitimate headwinds for businesses that are not always the toll roads that industry promoters claim they are, explains Josh Peters, editor of Morningstar DividendInvestor.

But if it’s not too early to be selectively greedy, it’s certainly not too late to be generally fearful. If energy prices don’t rebound soon, more halts to distribution growth as well as outright cuts are probably coming.

These actions could cast the whole group—even top-shelf names like ours—in a poor light for a while.

Oil that is only worth drilling for at $100 a barrel will stay in the ground at $45. Less drilling activity means lower production, lower production means less midstream infrastructure is needed, and with less investment we can expect distribution growth rates to fall across the industry.

1) All three provide excess coverage for distributions that is healthy relative to the volatility of their cash flows. SEP has extremely stable cash flow, so its coverage of 1.1 times still offers an appropriate buffer.

Magellan has a bit more variability, but if anything, its coverage of 1.4 times is far higher than it needs to be.

Of our three holdings, Enterprise is the most sensitive to energy prices, but its coverage ratio of 1.4 times does more than provide an adequate margin of safety.

2) All three of these partnerships are likely to continue increasing their quarterly distributions.

Thanks to new fee-based assets and growth for its favorably regulated refined products system, Magellan remains on track to raise its distribution 15% this year and 10% (or better) for 2016.

SEP has a huge backlog of heavily contracted projects in place to drive continued growth of $0.0125 a unit each quarter (about 8% annually) through 2017.

At Enterprise, new projects being placed in service plus the shield of substantial excess coverage make the current trend of $0.005 a unit quarterly hikes likely to continue through the current downturn.

As an investor, I think it’s best to approach this decline from a position of fear, while taking advantage of attractive valuations by gradually raising our stakes in high-quality firms.

We don’t need a pound-the-table moment; continued consistency from our selected MLPs will do fine.